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Introducing the new paradigm of emotional finance

09 March 2018

A while back, Richard Taffler, Professor of Finance at Warwick Business School and Fellow of the CFA UK was having a friendly chat with his neighbour, a professor of psychoanalysis, about dot-com mania and how existing explanations based on traditional economic theory seemed insufficient. Professor Taffler quickly realised that in order adequately to explain such stock market bubbles, a study of unconscious fantasies and psychodynamic processes was necessary, and he commenced upon a body of research in this nuanced field. He quickly found that little attention had been paid in the finance literature to how people’s unconscious thoughts and feelings help drive their investment decisions, and stock market behaviour more generally.

Conventional finance assumes decision makers are rational. Behavioural finance recognises that we are imperfect and often irrational, although believes that we can learn to be be ‘rational’ if we understand the cognitive biases to which we are prone. However, even behavioural finance ignores the vital part our unconscious needs, fantasies and anxieties play in all financial activity. This is the realm of emotional finance, the new paradigm in finance Professor Taffler is developing.

Professor Taffler is applying his seminal work in a range of areas in investment, including looking at how stocks and other assets are valued, not just on fundamental economic criteria, but also in terms of their emotional resonance and unconscious meaning for investors. Bitcoin’s apparently inexplicable gravity defying recent price rise and subsequent collapse which trumps the Dutch Tulip Bulb bubble even more than dot-com mania clearly highlights the need to go beyond traditional models in seeking to explain financial market behaviour.* Professor Taffler’s research shows that such financial bubbles tap in to investors’ unconscious fantasies, so recognising the role of investor emotions and tendency to wishful thinking is key to understanding such phenomena.

Professor Taffler’s research also looks more generally at the asset management industry and the real role it plays for investors, which is not just to help them earn higher returns, but arguably more importantly, to meet their underlying, and usually unrecognised, psychological needs. Investment managers are expected to produce consistent results in an environment which is inherently unpredictable, and this leads to a ‘pressure-cooker’-like experience and high levels of anxiety. The emotional ramifications have not previously been formally explored, and yet recognising these is vital to any proper understanding of the fund management industry’s often dysfunctional nature. In fact, Professor Taffler’s research suggests that the sooner the industry acknowledges its important psychological role, the better equipped it will be to help investors deal with an uncertain, and at times daunting, future. Professor Taffler shows how in the face of uncertain and volatile returns all investors are buffeted between powerful, if not always conscious, feelings of excitement and anxiety. Yet, the task of helping investors manage and deal with the consequences of these conflicting emotions so they are able to invest and stay invested despite the vagaries of the markets is not traditionally addressed by investment firms.

Interestingly, market practitioners and fund managers find emotional finance concepts very helpful not just to help them in their day-to-day investment decisions, but also in giving them a language to talk about and help explain what they are doing, and to support a dialogue that more traditional finance theories don’t address.

Professor Taffler’s most recent research shows how individual stocks are valued, not just in terms of expected risk and return, but also in terms of what they represent to investors emotionally and which is directly priced by the market. This is again not recognised in conventional financial valuation models. Being able formally to measure the unconscious meaning different stocks have for investors can identify those which are undervalued or overvalued. This is an area that Professor Taffler is currently working on with a view to developing appropriate profitable trading strategies, and more generally understand market pricing inconsistent with financial theory.

In summary, by acknowledging the vital role unconscious forces play in investment decisions, emotional finance provides a very practical framework that can help explain and predict market activity and asset valuations which traditional financial theories have problems in doing.